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    Sep. 27, 2012

First Loss Capital Arrangements for Hedge Fund Managers: Structures, Risks and the Market for Key Terms

First loss capital arrangements – like their cousins, seed capital, acceleration capital and founder share classes – are a means of obtaining hedge fund trading capital outside of the typical limited partner or investor channels.  Generally, in a first loss capital arrangement, a first loss capital provider and a hedge fund manager both contribute capital to a managed account; the manager has trading discretion over the account and bears, as the name implies, the first losses from trading in the account; and the capital provider pays the manager significant fees on net capital appreciation.  The chief benefits and burdens of first loss capital arrangements are implicit in the name.  The chief benefit is capital, which in today’s environment is increasingly hard to come by – especially for the smaller and midsize managers that typically enter into first loss capital arrangements.  (Interestingly, first loss capital is not just hedge fund “venture” money; more established managers routinely access first loss capital for a range of purposes.)  The chief downside is that the manager itself bears the loss of its contributed capital, which is typically proprietary or friends and family money.  Managers can feel the pain of investment losses in first loss arrangements to a degree that is unfamiliar to professionals accustomed to handling what Justice Brandeis famously termed “other people’s money.”  To assist hedge fund managers in applying the typical benefits and burdens of first loss capital arrangements to the facts of their individual circumstances, this article discusses: the definition of first loss capital arrangements; typical structures of first loss capital arrangements (including numerical examples); the identities of first loss capital providers; the “market” for terms of first loss capital arrangements (including losses, performance fees and termination and withdrawal provisions); the rationale, from the hedge fund manager perspective, of entering into first loss capital arrangements; the risks from the manager perspective of entering into such arrangements; and specific pitfalls to avoid when entering into such arrangements.  First loss capital arrangements can be valuable in raising capital quickly and developing a track record.  See “Portability and Protection of Hedge Fund Investment Track Records,” Hedge Fund Law Report, Vol. 4, No. 40 (Nov. 10, 2011).  But there are quite a few traps for the unwary – and many of those traps can be identified and mitigated through careful legal structuring.  First loss capital arrangements, in short, are an area in which considered legal review can yield tangible investment advantages and can avoid structuring missteps.

So You Don’t Want to Take the Series 3 Exam?  Alternatives to the General Proficiency Requirement for Associated Persons of Commodity Pool Operators and Commodity Trading Advisors

Recent amendments to U.S. Commodity Futures Trading Commission (CFTC) rules have required many hedge fund firms to confront the prospect of registering with the CFTC as a commodity pool operator (CPO) and/or commodity trading advisor (CTA).  Notably, the CFTC in February announced the rescission of Rule 4.13(a)(4), a CPO registration exemption that for years has allowed hedge funds to trade without limitation in CFTC-regulated “commodity interests” (i.e., futures contracts, options on futures, retail f/x transactions and, effective October 12, 2012, many types of swaps).  Going forward, most U.S. hedge fund firms that operate funds for which they cannot rely on the alternative CPO registration exemption in Rule 4.13(a)(3) – which imposes significant limits on a fund’s commodity interest trading – will have little choice but to register with the CFTC.  For firms registered as investment advisers with the U.S. Securities and Exchange Commission, many aspects of the CFTC registration process, as well as certain ongoing recordkeeping, reporting and disclosure obligations, will be familiar.  But one area where the CFTC requirements for registered CPOs and CTAs depart significantly from the norms of SEC investment adviser regulation is the general requirement that a CFTC registrant’s marketing personnel (so-called “associated persons” or APs) satisfy certain proficiency testing requirements – in general, timely passage of the “Series 3” examination.  In a guest article, Sean Finley, Jared Gianatasio and Nathan Greene summarize the scope of a CPO’s or CTA’s personnel who will be APs generally subject to the Series 3 proficiency requirement and highlight several exemptions and proficiency testing alternatives that can offer relief from that requirement.  Finley is a partner, Gianatasio is a senior associate and Greene is a partner and Co-Practice Group Leader in Shearman & Sterling LLP’s Asset Management Group.

Cayman Grand Court Rejects Validity of Side Letter Entered Into Between an Investor in Investment Vehicles That Invested in the Matador Fund and a Director of the Matador Fund

A recent decision handed down by the Grand Court of the Cayman Islands (Court) emphasizes the importance of: (1) ensuring that the correct parties enter into side letters between an investor and a fund; and (2) ensuring that a fund’s governing documents permit the fund to enter into the type of side letter contemplated by the fund and the investor.  This decision follows on the heels of another recent decision handed down by the Court that highlights similar principles.  See “Recent Cayman Grand Court Decision Demonstrates the Practical and Legal Challenges of Investing in Hedge Funds through Nominees,” Hedge Fund Law Report, Vol. 5, No. 29 (Jul. 26, 2012).

BNY Mellon Study Identifies Best Risk Management Practices for Hedge Fund Managers

In the last few years, hedge fund managers, investors and regulators have identified a growing roster of risks facing hedge fund investments and operations.  See, “SEC Provides Recommendations for Establishing an Effective Risk Management Program for Hedge Fund Managers at Its Compliance Outreach Program Seminar,” Hedge Fund Law Report, Vol. 5, No. 4 (Apr. 5, 2012).  As a consequence, investors and regulators are increasingly demanding effective, appropriately tailored risk management systems, and managers are making an ongoing effort to divine best practices.  Recognizing and reflecting this trend, BNY Mellon issued a research study in August 2012 that provides a roadmap of the state of risk management in the hedge fund industry, risk management trends and best practices.  This article summarizes the key points from the study, with particular emphasis on tools and practices hedge fund managers can implement to identify, monitor, mitigate and report on risk.  See also “Ernst & Young Survey Shows Risk Managers Possess Tremendous Influence and Face Substantial Challenges in the Asset Management Industry,” Hedge Fund Law Report, Vol. 5, No. 23 (Jun. 8, 2012).

Baupost Group Hedge Funds Seek to Force Bear Stearns Unit to Repurchase 1,100 Mortgages Sold in a 2007 Securitization

In a February 2007 mortgage securitization, defendant EMC Mortgage LLC (EMC) sold over 2,000 mortgages to the Bear Stearns Mortgage Funding Trust 2007-AR2 (Trust).  In an action commenced in the Delaware Court of Chancery (Chancery Court), the Trust is seeking to force EMC to repurchase more than half of those mortgages.  It alleges that EMC breached numerous representations and warranties relating to the underwriting of the mortgages in question and showed “callous disregard for prudent [loan] origination protocol.”  It also claims that, with respect to the few dozen mortgages that EMC has agreed to repurchase, EMC has miscalculated amounts it owes to the Trust.  This article summarizes the Trust’s allegations.  See also “For Hedge Funds, Ownership of Commercial Mortgage-Backed Securities Servicers Offers a Growing, Uncorrelated Stream of Fee Income and Advantageous Access to Distressed Mortgages, But Not Without Legal and Business Risk,” Hedge Fund Law Report, Vol. 2, No. 38 (Sep. 4, 2009).

Second Circuit Upholds Dismissal of Hedge Fund Investors’ Securities Fraud and Negligence Suits Against Fund Auditors, KPMG and Ernst & Young, Based on their Alleged Failure to Detect Madoff Fraud

Individuals and hedge funds that invested in certain Bernard L. Madoff feeder funds that were managed by Tremont Group Holdings, Inc. and its affiliates (Tremont) initiated lawsuits in the U.S. District Court for the Southern District of New York (District Court) against Tremont and accounting firms KPMG LLP, KPMG (Cayman) and Ernst & Young LLP (together, Auditors).  The plaintiffs claimed that the Auditors were liable for securities fraud, common law fraud, negligence and breach of fiduciary duty arising out of their audit of certain Tremont funds that invested with Bernard L. Madoff Investment Securities, LLC (Madoff) and their failure to detect the Madoff fraud.  The District Court granted the Auditors’ motion to dismiss the complaint for failure to state a claim against the Auditors.  The U.S. Court of Appeals for the Second Circuit has upheld that dismissal.  This article summarizes the investors’ claims as well as the Court of Appeals’ decision and reasoning.

Ex-Cadogan CCO Harris Bogner Joins Avalon Lake Partners

On September 27, 2012, in response to increased demand for outsourced compliance services in the marketplace, Avalon Lake Partners announced that it has brought on Harris Bogner to head its compliance services group.

Andrew Bowden Named Deputy Director in the SEC’s Office of Compliance Inspections and Examinations

On September 12, 2012, the Securities and Exchange Commission announced that Andrew J. Bowden has been named Deputy Director of the agency’s Office of Compliance Inspections and Examinations.  He succeeds Norm Champ, who was named in July to head the SEC’s Division of Investment Management.

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